Almost everyone is affected by the strong dollar

Almost everyone is affected by the strong dollar
Almost everyone is affected by the strong dollar

Slightly above, slightly below, but always very close: the exchange rate of the US dollar against the euro has been moving around one to one: one dollar per euro for two weeks now. As if this ‘parity’ in the exchange rate has a magnetic attraction. A vacation in the US has become very expensive. Conversely, American tourists were surprised this summer about the affordability of Europe.

The dollar has not been as strong as it is today for twenty years. Only just before the introduction of the euro in 1999, when the single European currency had yet to prove itself, was the euro weaker than it is today. But where does the dollar’s current strength come from?

The eurozone, and virtually all of Europe except Switzerland, is struggling with a weakened currency. The same goes for Japan and many emerging and developing countries: the dollar is strong against almost every other currency. This can be seen from the dollar index: an average exchange rate of the dollar against the currencies of America’s most important trading partners. It is now at its highest level since June 2002.

On paper, a weakening currency isn’t all that bad – as long as it doesn’t last too long or become structural. Companies are now selling their products in the US at a much better price: the so-called ‘transaction effect’. Calculated in euros, the dollar profits made by their American subsidiaries yield more: the ‘translation effect’. And the competitive position compared to American opponents is improving: the ‘economic effect’.

But there is a big drawback to that. The price of imports of products and services from the US rises as the currency in which you buy them increases in value. The eurozone, with inflation now at 9.1 percent, finds it difficult to use such an additional price hike. This is even more true for many other countries, especially emerging economies and developing countries. Here, too, inflation is boosted by the expensive dollar.

dollar dominance

The dominance of the dollar, which is still strong despite all the predictions about a declining role of the US in the global economy, is taking its revenge. The International Monetary Fund states that 40 percent of all invoices for imports of goods and services worldwide are denominated in dollars. Even if it concerns two countries that do business with each other, and do not import any American goods or services at all. If they don’t fully trust each other’s currency, they prefer to transact in that one, solid and neutral currency from America.

If you want to import oil, metals or grain, you must have dollars

Commodities play an important role in that dollar dominance: they are still overwhelmingly settled in dollars. Virtually anyone who wants to import oil, metals or even grain has to pay in dollars, so stock it or earn it elsewhere. But even excluding commodities, a quarter of global trade is still in the US currency.

In addition, many foreign debts are denominated in dollars, and are currently becoming more expensive to repay. Countries that export commodities benefit from a rise in the price of these goods, which are also settled in dollars on top of that. But the rest is having an extra hard time: expensive imports of raw materials, especially energy, in expensive dollars. ING pointed out in an analysis this week that even South Korea, an export champion pur sang, has seen monthly trade surpluses of usually around USD 10 billion turn into a monthly deficit of USD 10 billion.

How problematic the expensive dollar becomes for emerging and developing countries depends on the strength of the US currency. Foreign investors and debt holders are now increasingly seeking the exit. The International Institute of Finance, the banks’ international think tank, states that $9.8 billion was withdrawn from emerging countries in July. That’s the fifth consecutive month of outflow of capital, and it’s never been this long.

Exchange rate

In comparison, Europe’s problems are modest. The position of the euro is so strong that the dollar plays a very modest role in payments for imports and exports. But inflation is a problem: a weak euro further fuels inflation, which is exactly what the eurozone cannot use. The European Central Bank is there to defend the internal value of the euro: inflation equals the erosion of the value of the currency. But the external value of the euro also plays a role: the exchange rate. And at the moment, the exchange rate of euro and dollar is especially important. The euro is largely stable against most other currencies.

The big question is how the relationship between euro and dollar will develop. There are so many different influences on an exchange rate – economic, financial, monetary and political – that it is notoriously difficult to predict. It is clear, however, that interest rates have recently played a major role: a high interest rate favors a currency, especially in the short term. The US central bank, the Federal Reserve, has already raised its rate this year by 2.25 percentage points to between 2.25 percent and 2.5 percent. The European Central Bank was slower, and more modest, raising interest rates by half a percentage point, bringing the traditionally most important rate, the main refinancing rate, to 0.5 percent. That, according to most analysts, has been the driving force behind the dollar’s rise – or the euro’s weakening – by some 12 percent since the beginning of the year.

Much now depends on future interest rate policy. Last week, in Jackson Hole, USA, both the Fed and the ECB made clear that they would take further strong interest rate steps to stamp inflation out of the economy – if necessary at the cost of a significant slowdown in economic growth or even a recession. Next week, on Thursday, the ECB will be the first to act. Analysts are increasingly counting on a significant increase of 0.75 percentage point. So much so that the financial markets may react disappointed if the step is smaller than that. The uncertainty may explain why the dollar and euro will remain around that magnetic one-to-one exchange rate for the time being.

The article is in Dutch

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